Ilargi: Consumer confidence is up, not just in the US, but also in France, Italy, Germany and undoubtedly in many other places, with the possible exception of Mexico. After having witnessed stock markets go up quite a bit, consumers would be expected to feel a little better, certainly with spring on or over the doorstep. Naturally, these numbers have little concrete meaning, but there's nothing like feeling good. I don't know what questions people are asked when their feelings are probed, they may well be reasonable queries, but I have doubts when I read that fewer people in the US now think jobs are "hard to get". That little example contradicts employment numbers about as much as conceivable, and it makes me wonder if those who "feel" jobs are now easier to come by do so because they're simply not looking anymore.

More "good news": the rate of house price declines seems to have stopped accelerating, leading many "analysts to conclude that words like "bottom" can be thrown back into the fold. Henry Blodget at Clusterstock, admittedly after saying prices have much more to fall, concludes: "[..] this is, finally, the first sign of a turn." See, that's where and when I wish people would try harder not to look ridiculous. This sort of forced good tidings thing is dangerous; people will believe it and spend their money accordingly. And they will lose it. The home price story is best summed up thusly: "home prices don’t set new plunge record for first time in 16 months". For 16 consecutive months, each fall was worse than the one before. February was the first in that line not to set a new record. To call that the first sign of a turn is highly irresponsible. If for no other reason (though there are many), for this: "The percentage of people who said they plan to buy a home in the next six months dropped to a 26-year low in March"

Amidst the euphoria, we're encouraged to forget what's really going on: the two biggest US banks have failed the stress tests. There's no surprise there for anyone who's kept half an eye open lately, but neither does this news have the power to bring markets down. Why? Because everyone is convinced that the US government and the Federal Reserve will come up with a plan, any plan, to bail them out once again. The rate of perverted thinking and acting accelerates, and the markets have already discounted that in prices. The most glaring example of that perversion is still found at Freddie Mac and Fannie Mae, who buy up any mortgage loan that is offered to them, leading to the afore-mentioned first non-record-setting drop in the Case-Shiller Index in 16 months. Without them, you could count home sales in eth US on your two hands by now.

I received an email from Barry RItholtz recently in reaction to a piece I wrote last week, Fool's Gold for Fair Value, in which I suggested that many professionals in the finance world have a blind spot when it comes the potential consequences -and the overall reality- of our present crisis, a spot that is evident, I said, in their failure to recognize the main underlying issue: there is no credit left in the system. Ritholtz replied that in his view, the problem is that too few people qualify for credit, but ”there is plenty of credit around (after all, 4.5 million homes will be sold this year, and I think we can assume SOME of those millions of purchases will be with a mortgage)". I will, of course react in private mail to Barry, and I mean no disrespect in quoting private correspondence, but I wanted to bring this up here, because I think he proves my point that there is a blind spot.

There truly is no actual credit left in the system. The banks that provide the majority of the loans that still exist out there are insolvent, and need billions, if not trillions, in additional capital fromn the taxpayer, even after they've already gotten humongous amounts in taxpayer funds. That's not the real thing; at best it's artificial credit. Now we could of course argue that all credit in the past 10-15 years has been artificial, but we’ll leave that for later. The homes that still sell in eth US are backed by mortgages that are backed by Fannie and Freddie, i.e. the taxpayer. This is not credit, this is the real estate equivalent of the model of the US economy that depends on people flipping each other's burgers. And when, inevitably, tax dollars can no longer be used to prop up the mortgage and housing industries, home prices will fall so fast and furious that they will drag down these already artificial industries to lows nobody today wants to admit the existence of.

And Henry Blodget's misleading line "[..] this is, finally, the first sign of a turn" can best be countered with another set of numbers in today’s news. "The share of mortgages in foreclosure rose to an all-time high of 3.3 percent in the fourth quarter [..]. Delinquencies, or the percentage of home loans that have payments 30 days or more overdue, increased to 7.88 percent, the highest in records dating to 1972 [..]. Banks held $11.5 billion of foreclosed properties in the fourth quarter, up from $6.5 billion in the year-earlier period".

US consumers turned considerably more confident in April, with more seeing a bottom taking shape in the recession-stricken economy, the Conference Board said Tuesday. The business research group's consumer confidence index, based on a representative sample of 5,000 US households, leapt to 39.2, up from a revised 26.9 in March, a gain of nearly a point from that month's initial estimate. Most economists had predicted a more modest rise in the April index, to 29.9. The last time consumers were so positive was in November. The index hit bottom in February, at 25.3, its lowest level since tracking of the seasonally adjusted data began in 1967.

"Consumer confidence rose in April to its highest reading in 2009, driven primarily by a significant improvement in the short-term outlook," said Lynn Franco, the Conference Board's research director. Franco said that while the index on the current situation improved moderately, the expectations index for six months forward sharply increased, suggesting that "consumers believe the economy is nearing a bottom." Nevertheless, she pointed out, that index remained "well below" levels associated with strong economic growth. The present situation index rose to 23.7 in April from 21.9 in March. The expectations index advanced to 49.5, its highest level since the global financial crisis accelerated sharply last September, from 30.2 in March. Despite the strong leap in the headline reading, "the numbers are very weak still," said Ian Shepherdson, chief US economist at High Frequency Economics.

"There is still a long, long way to go," he said, to recover from the entrenched recession that began in December 2007. The survey, concluded on April 21, found that the number of consumers viewing current business conditions as "bad" fell below 50.0, to 45.7, down from 51.0 in March. Those believing business conditions were "good" rose to 7.6 percent from 6.9 percent. Despite unemployment at a 25-year high of 8.5 percent in March and a growing number of layoffs, the Conference Board survy found a slight improvement in consumers' jobs outlook. Respondents saying jobs were "hard to get" slipped to 47.9 in April from 48.8 in March. But those seeing "plentiful" jobs also declined, to 4.5 from 4.7 last month.

Regulators have told Bank of America Corp. and Citigroup Inc. that the banks may need to raise more capital based on early results of the government's so-called stress tests of lenders, according to people familiar with the situation. The capital shortfall amounts to billions of dollars at Bank of America, based in Charlotte, N.C., people familiar with the bank said. Executives at both banks are objecting to the preliminary findings, which emerged from the government's scrutiny of 19 large financial institutions. The two banks are planning to respond with detailed rebuttals, these people said, with Bank of America's appeal expected by Tuesday.

The findings suggest that government officials are using the stress tests to send a tough message to struggling banks. Bank of America and Citigroup have been the highest-profile problem children in recent months, but it is unlikely that they are the only banks the Federal Reserve has determined might need more capital. Industry analysts and investors predict that some regional banks, especially those with big portfolios of commercial real-estate loans, likely fared poorly on the stress tests. Analysts consider Regions Financial Corp., Fifth Third Bancorp and Wells Fargo & Co. to be among the leading contenders for more capital. Wells Fargo declined to comment. Representatives of Regions and Fifth Third didn't respond to requests for comment made late in the day.

Government officials say their meetings about the stress tests with bank executives over the past few days conveyed preliminary results and that discussions were expected to continue this week about specific findings. They also say that banks directed to raise more capital shouldn't be viewed as insolvent. Instead, the capital is intended to cushion the banks against potential future losses under dire economic conditions. Federal officials say they won't allow any of the top 19 banks to fail. Still, it is unclear how flexible the government will be about adjusting the results, especially as banks plead their cases individually. Banks have until the middle of this week to lodge their formal responses to the tests. Bankers expect that will set the stage for several days of intense negotiations between the banks and their examiners. While the Fed initially planned to release the results of the stress tests on May 4, the government says the results will be released sometime that week.

Banks that are deemed to need more capital will have six months to find it, either from private investors, other financial institutions or the U.S. government. Bank of America and Citigroup have required a total of $95 billion in taxpayer infusions, and the government has agreed to protect the banks against most losses on hundreds of billions of dollars worth of assets. Bank of America's capital hole as measured by the regulators is in the billions, said people close to the company, placing added pressure on management as the company prepares for a Wednesday shareholder meeting in Charlotte. It isn't clear how big a capital deficit Citigroup faces. At meetings Friday at the New York Fed's fortress-like headquarters near Wall Street, government examiners informed Citigroup executives that the preliminary stress-test results indicated the company needed more capital, according to a person familiar with the matter. A spokesman for Citigroup declined to comment.

Bank of America has already taken $45 billion in capital from the federal government, some of it to help the bank cover losses stemming from its purchase of securities firm Merrill Lynch & Co.If the bank is forced to bolster its capital, it could do so in one of several ways, including selling assets, selling more shares to the public or converting the government's preferred shares into common stock. That would boost the company's capital on paper but could also leave the U.S. government as Bank of America's largest shareholder while diluting the value of the stock held by existing shareholders.

Raising capital in the current environment is nearly impossible for troubled financial institutions. Skittish investors are wary of plowing money into banks that still face potentially large losses. But institutions perceived as healthy have had some success luring investors. Goldman Sachs Group Inc. earlier this month sold $5 billion of its shares, and plans to use the funds to repay the government's capital infusion. Northern Trust Corp. said Monday that it plans to sell $750 million of common stock in a public offering. Like Goldman, Northern Trust said the proceeds will help it close out the U.S. investment in the Chicago-based company. Citigroup wants to get credit for its recent efforts to shrink its balance sheet by selling businesses such as Smith Barney and its Japanese brokerage arm, say people familiar with the matter.

While those deals haven't yet been completed, they're expected to ultimately give a significant boost to Citigroup's capital levels. In addition, Citigroup executives have concerns about some of the assumptions the Fed used in calculating the timing and severity of future losses on consumer loans such as credit cards, according to one person familiar with the matter. The preliminary test results added to frustration that already had been building at Citigroup as the government conducted its stress tests over the past two months. During that process, executives have griped that examiners were demanding detailed information from every corner of the sprawling organization, consuming thousands of man-hours without briefing anyone on what the government was looking for, according to people familiar with the matter.

The regulators are asking "a million questions" and it's "very unclear what they're aiming at," one senior executive said earlier this month. "We can't discern a pattern." Some bank executives have said that even after meeting with Fed examiners on Friday, they still don't understand details of the government's methodology for conducting the tests. A spokeswoman for the Fed declined to comment on the stress tests. One question is how the government is projecting banks' revenue streams through 2010. Some bankers are optimistic that the Fed will use their first-quarter numbers to predict their performance for the next two years. That could inflate the banks' earning potentials -- and thus their capital cushions -- because many of the companies had strong first-quarter performances. Analysts, investors and most executives say those results probably aren't sustainable.

Federal Deposit Insurance Corp. Chairman Sheila Bair, looking beyond stress tests that will determine the health of the top 19 U.S. banks, said her agency should have the authority to close even the biggest lenders. The "too-big-to-fail concept" should be "tossed into the dustbin," and the FDIC should have the power to close "systemically important" financial firms, Bair said in a New York speech yesterday. "Given our many years of experience resolving banks and closing them, we’re well-suited to run a new resolution program," she said. Analysts are recalibrating their estimates of the results of the federal bank examinations after the government announced the test methodology last week. Lenders were given preliminary results on April 24 and have time to discuss them with regulators before the full readings are released on May 4.

"If the FDIC had the authority to close down non-banks as they’ve been able to close down banks, the cost to the taxpayer would have been much less," said Sung Won-Sohn, former chief economist at Wells Fargo & Co. who is now a professor of economics and finance at California State University Channel Islands in Camarillo. "With the authority she’s talking about, the government could take preemptive action." Bair said the results of the stress tests will be released in a way that enhances public confidence and won’t damage any institution. "We’re ahead of it," Bair said yesterday in an interview after speaking at a Financial Women’s Association dinner in New York. "It will instill confidence, not the other way around." Regulators are weighing how much information to disclose and how much of an additional buffer banks may need, she said. "It’s not a pass-fail," Bair said. "It’s not a solvency test."

U.S. regulators have provided more than $90 billion to Citigroup Inc. and Bank of America Corp., given more than $180 billion in loans to American International Group Inc. and established debt-guarantee programs. The FDIC wound down 29 failed banks and thrifts this year. Bank of America and Citigroup have been told by regulators that they may need to raise more capital as a result of the stress tests, the Wall Street Journal said, citing people familiar with the matter. Analysts including Richard Bove of Rochdale Securities say the stress tests aren’t useful. "This test still strikes me as being unnecessary, dangerous, and poorly conceived," Bove wrote in an April 25 note to clients. "My fear is that this program will not only fail to raise more capital, but it will force banks to contract."

Regions Financial Corp., the Alabama bank that has accepted $3.5 billion in U.S. assistance, declined 12 percent in New York trading yesterday as analysts said regulators may push the company to raise more capital to offset mounting losses. The bank "probably has been told to raise additional equity capital with $7 billion to $8 billion of projected 2009- 2010 losses vs. $4 billion to $5 billion of pretax, pre- provision income," analyst Jeff Davis of Howe Barnes Hoefer & Arnett Inc. said in a report yesterday. Giving the FDIC the authority to shut bank-holding companies, insurers and other large institutions instead of just failed commercial banks would shield taxpayers from absorbing losses, Bair said. "The FDIC is up to the task, and whether alone or in conjunction with other agencies, the FDIC is central to the solution," Bair said.

The absence of the authority "has contributed to unprecedented government intervention into private companies," Bair said. "Taxpayers should not be called on to foot the bill to support non-viable institutions because there is no orderly process for resolving them." Bair recommended it be formed under a "good bank-bad bank" model, in which the government would take over troubled firms and force stockholders and unsecured creditors to pay the costs. "Viable" portions of the company would be put into the good bank, while the ailing portions would remain at the bad bank to be sold or closed over time, Bair said. The costs imposed on the stockholders and unsecured creditors and fees collected from other "systemically risky" firms would pay for the bad bank, Bair said. "This has the benefit of quickly recognizing the losses in the firm and beginning the process of cleaning up the mess," she said.

At the height of the SARS epidemic in 2003, Hong Kong's Mandarin Oriental Hotel was reduced to a single paying guest. Cathay Pacific Airways cut 42pc of its flights in Asia. Few people actually caught the disease. Just 813 people died worldwide, less than deaths from normal flu every day. Yet the human reaction – some say panic, others say wise evasion – was enough to bring the Pacific Rim to its knees for months. Estimated losses were $30bn (£20bn). The rebound was swift. The SARS episode is a foretaste of the damage that can be done by epidemics in a modern global economy, where the media transmits instant angst. But only a foretaste. Flu is more contagious than a coronavirus like SARS. What makes flu pandemics so menacing is that they are both highly infectious and deadly. They are also rare: just 11 in 300 years.

We do not yet know enough about the H1N1 strain of swine flu sweeping Mexico to judge its virulence. The World Health Organisation has called it a "public health emergency" but has not yet pushed the full pandemic button – a crucial distinction. The WHO's emergency committee will discuss today whether to raise the alert to Phase 4 (sustained human to human) or even Phase 5 (widespread human infection), said spokesman Dick Thompson, A raft of studies have already been published on the economic risks of an avian flu pandemic. They are equally valid for Mexico's swine mutation, if the worst-case scenario unfolds, and they make grim reading at a time when the global economy is already on fiscal and monetary life-support. A World Bank study in 2008 estimated that a "severe pandemic" like the 1918-1919 Spanish flu could lead to 70m deaths, costing up to $3 trillion in lost output or 4.8pc of global GDP. Can the world's fragile banking system survive such a hammer blow?

The US government's Pandemic Influenza Strategic Plan – confidential, but leaked – said an outbreak would cause mayhem, with power blackouts and fuel and food shortages. The closure of schools would force parents to stay home. There might be riots at vaccination centres. Parts of the country would be quarantined. The US Congressional Budget Office reached much the same conclusions, saying 90m Americans would be infected. A third of the workforce would stay at home to look after their families, or refuse to go to work until the danger had passed. "The virus would spread very widely in a very short time. In any geographic region, each wave could last three to five months," it said. US losses would be $675bn. Markets have responded calmly so far, betting that Mexico's epidemic will prove a false scare. Fear reflexes kicked in for a few hours yesterday. Oil and metal prices fell. Frankfurt's DAX index slid 1.6pc and Paris's CAC dropped 1.7pc. US Treasury bonds rallied a few ticks. The dollar, yen and Swiss francs rose. But Wall Street was back on its feet by the afternoon, perhaps because so few market players are scientifically literate.

Michael Osterholm, a world authority on pandemics at the University of Minnesota, said it was impossible to judge whether this was the "big one" until data has been collected in Mexico, and the US and Canadian authorities have tested the new strain. "This could die out over the next couple of weeks, or this could be the opening act of a full-fledged pandemic." There is wide agreement among the world's tight-knit group of virologists that the H1N1 virus may prove very dangerous as it mutates. Stephen Lewis, from Monument Securities, said markets have become blasé after years of bird flu scares. "The stories never came to anything so people just assume that this won't turn into a pandemic either. But H1N1 is very different. It is already spreading from human to human and there is a real risk that it will attack populations in countries where Tamiflu is not available," he said.

"If this had hit when the global economy was buoyant, it would have knocked us back to where we are now. But at this stage it could have exponential effects, leading to collapse." Cases in the US and Canada have so far been mild. WHO officials are keeping their fingers crossed that equally mild cases have occurred in Mexico, as yet unreported. That would lower the fatality rate and suggest a more manageable outbreak, even if it turns into a "light" pandemic akin to Hong Kong flu in 1968. The 1918 pandemic killed 3pc of mankind. At one point priests went through Philadelphia with carts calling families to bring out their dead, like the Black Death. Young adults were hit hardest as their immune systems went into overdrive, causing them to drown from cykotene shock.

Ominously, the same age group seems to suffering worst in Mexico. Even so, there is little risk of deaths on the same scale. The authorities were flying blind in 1918. Scientists did not even know it was a flu virus (some said it was plague). Today's experts are ready to pounce. Vaccines can probably be mass produced in eight weeks or so. Yet the economic risk is as great as ever. So far it is Mexico that is bearing the cost, with a tumbling peso and bourse. But a virus respects no borders.

I just had coffee with Mohamed El-Erian, who pointed out to me that he didn’t actually push the PPIP plan, as I said he did. He just said that the government needed a plan to deal with toxic assets, and that some plans made a lot more sense than others. On the subject of PPIP, though, I did ask El-Erian about how much value there is in clipping tails. If the government promises to absorb all losses beyond the first 15 cents on the dollar, how much does that raise the amount of money you’re willing to pay for any given asset? I was trying, in effect, to come at a value for the FDIC guarantee in the PPIP plan, but I didn’t get very far.

The answer, you see, is basically "it depends". Every asset has a different probability distribution, and if you think that there’s a good chance the asset is actually worth 90, the tail-clipping at 85 is much more valuable than if you think the asset in reality is more likely to be worth 110. In short, it’s a long and laborious process of looking at every asset individually determining a probability distribution, and doing some math on it. How many good credit analysts are out there and capable of doing that kind of analysis? I think it’s not nearly enough, but El-Erian is a bit more bullish on that front: he thinks that if you create the right incentives, people will start to work this stuff out.

We also talked a bit about the probabilities of a big secular shift into a whole new world of class warfare or even real warfare. El-Erian asked me what I thought the probability of that was, and I pulled a number out of thin air: 20% to 25%. After all, it’s simply a truism to say that historically speaking, long periods of peace and prosperity end with war and destruction. And the rise of global markets and economies since 1945 has certainly been a long period of time, which seems in many ways to be coming to an end. El-Erian’s response was to say that probabilities that high aren’t remotely priced in to the market, which I think is undoubtedly true. People are happy talking about big-picture geopolitical risks, but they tend not to invest on that basis; instead, they habitually revert to thinking about "bottoms" and the like. Old emerging-market hands like El-Erian and myself are probably more prone to thinking about entire countries going to zero than most investors are — but I suspect that more and more people are going to be thinking along such lines over the coming months.

The Case/Shiller index showed another deep drop in home prices for February, but the plunge was no record. Home prices dropped sharply in February, but for the first time in 25 months the decline was not a record, another sign the housing crisis could be bottoming. The Standard & Poor's/Case-Shiller index released Tuesday showed home prices in 20 major cities tumbled by 18.6% from February 2008. That was slightly better than January's 19% and the first time since January 2007 the index didn't set a record. The 10-city index slid 18.8%, the first time in 16 months its decline was not a record. But the good news was mixed. All 20 cities in the report showed monthly and annual price declines, but half recorded annual records.

Prices fell by more than 10% in 15 cities, including Las Vegas, San Francisco and Phoenix. In fact, Phoenix home prices have lost more than half their value since peaking in July 2006. Yet, nine of the metros—including Dallas, Denver and Boston—showed improvement in their yearly losses compared to the month before. "We will certainly need a few more months of data before we can determine if home prices are finally turning around," said David M. Blitzer, chairman of the S&P index committee. Last week, data for March home sales also offered a conflicting picture of the housing market. Existing home sales fell 3% from February to March, while new home sales seemed to have hit bottom. Prices in the 20-city index have plunged 30.7% from their peak in the summer of 2006, and the 10-city index has lost more than 31.6%.

The February Case Shiller numbers confirmed the trend we've seen in other housing reports: The rate of decline in house prices is finally decelerating. This does NOT mean prices have bottomed. Far from it. This just means that, for the first time since the market peaked in 2007, the rate of plunge is finally slowing. House prices still fell 19% year over year in February, close to the peak rate of January. They are down almost 30% from the peak now, and they will likely bottom down at least 40% and probably closer to 50%. But this is, finally, the first sign of a turn.

Rate of decline finally slowing but still near the peak rate of 19%:

Prices now at 2003 levels and will decline considerably more from here:

A record 19.1 million homes stood unoccupied in the first quarter and the U.S. homeownership rate fell as the recession sapped demand for real estate. The number of vacant homes, including foreclosures, properties for sale and vacation properties, jumped from 18.6 million a year earlier, the U.S. Census Bureau said in a report today. Households that own their own residence declined for the third straight quarter to 67.3 percent. The U.S. financial crisis and falling home prices have shattered the confidence of homebuyers. The percentage of people who said they plan to buy a home in the next six months dropped to a 26-year low in March, according to the Conference Board in New York. Job losses will continue to erode real estate demand, according to an April 23 report by Mark Fleming, chief economist for First American CoreLogic Inc. in Santa Ana, California.

"We expect home prices to continue to decline into 2010 as economic conditions and excess housing inventories dampen prices," Fleming said in the report. "Decreases are now being driven by rising unemployment and a high volume of distressed home sales." The percentage of all U.S. homes empty and for sale, known as the vacancy rate, fell to 2.7 percent in the first quarter. It hit an all-time high of 2.9 percent in the first and fourth quarters of 2008, the Census Bureau said. The vacancy rate fell as the number of homes on the market declined because they were sold or because their owners gave up trying to market them. The inventory of homes on the market averaged 3.7 million in each of 2009’s first three months, according to data from the National Association of Realtors. Last year, the monthly average was 4.2 million.

There were 130.4 million homes in the U.S. in the first quarter, the Census Bureau said. In addition to the 2.1 million empty properties for sale, the report counted 4.2 million vacant homes for rent and 4.9 million seasonal properties that are only used for part of the year. Foreclosures are included in a part of the Census Bureau that also includes vacation homes intended for year-round use and homes that are unoccupied because they are under renovation. There were 7.9 million such properties empty in the first quarter, up from 7.5 million a year earlier, the report said. Foreclosures could also be counted as vacant homes for sale or rent, or as owner-occupied properties if lenders have not yet evicted previous owners, the agency said.

The economy has lost about 5.1 million jobs since the recession began in December 2007, the biggest drop of the post- war era. Economists surveyed by Bloomberg in early April said unemployment probably will rise to 9.5 percent by the end of the year, up from March’s 25-year high of 8.5 percent. The share of mortgages in foreclosure rose to an all-time high of 3.3 percent in the fourth quarter, the Mortgage Bankers Association said in a March 5 report. Delinquencies, or the percentage of home loans that have payments 30 days or more overdue, increased to 7.88 percent, the highest in records dating to 1972, the Washington-based trade group said. Banks held $11.5 billion of foreclosed properties in the fourth quarter, up from $6.5 billion in the year-earlier period, according to the Federal Deposit Insurance Corp. in Washington.

A $5 million Connecticut mansion. A $4 million London townhouse. A $7 million English estate. The houses are owned by three men CBS News has learned are now the subjects of a Justice Department criminal investigation into how AIG crumbled. Sources say investigators are digging into whether Joseph Cassano, the former head of London-based AIG Financial Products, and two of his top deputies - Andrew Forster, an executive vice president, and Thomas Athan, a managing director - committed securities fraud and other federal crimes, reports CBS News chief investigative correspondent Armen Keteyian. At issue: whether they intentionally provided false information about the size of AIG's loses in the mortgage-backed securities market to the public and auditors.

"They would look at the email traffic to try and see who was saying what to whom," said John Laperla, a former fraud investigator for the U.S. Postal Inspection Service. "The criminality would be if someone willfully intended to basically put in false information and ultimately defraud the general public and the stockholder," Laperla said. CBS News has learned investigators are honing in on statements like one in a September 30, 2007, quarterly report, where potential accounting losses tied to its Cassano's unit, known as AIGFP, were $352 million. And the company said it was "highly unlikely..{it} will be required to make payments." To clients, it was an indication the company was saying it was healthier than it actually was. Also under scrutiny is a November 7 press release where AIGFP upped that potential accounting loss to $550 million.

But by the end of the year the potential losses became real and devastating, ballooning to more than $11.5 billion. "That's a significant red flag," said Patricia Pileggi, a former federal prosecutor. "I mean a jump like that in three months raises real questions." In a statement AIG told CBS News: "To date, neither AIG nor AIGFP is aware of any fraud or malfeasance in connection with the underwriting and creation of the multi-sector CDS portfolio, as opposed to what, with hindsight, turned out to be bad business decisions. AIG and AIGFP are, however, aware of ongoing investigations by the Department of Justice and the SEC with respect to the subsequent valuation of the multi-sector CDS portfolio under fair value accounting rules and related disclosures. We have cooperated fully with these investigations and will continue to do so."

A senior AIG official told us: "Everyone at the corporate office was stunned when the problems with valuing the CDS portfolio came to light in February of 2008. It became clear immediately that the potential losses on the swaps were far greater than anyone imagined. That’s when (Martin) Sullivan asked (Joseph) Cassano to resign." Through their attorneys for both Cassano and Forester declined comment on our story. Athan's attorney said his client arrived at AIGFP after it "sustained substantial losses" and was working "to help minimize the continuing risk." And now CBS News has learned that Athan and Forster pocketed bonuses paid out by AIG just two months ago - in the midst of a federal investigation. Sources say they are now negotiating a way to pay them back.

Hong Kong banks sold notes linked to failed Lehman Brothers Holdings Inc. to elderly, poorly educated and mentally ill people, according to a central bank investigation that may fuel demands for better protection of the city’s investors. The Legislative Council released previously blacked-out sections of a Hong Kong Monetary Authority report showing 102 cases in which "vulnerable" investors were sold the credit- linked notes, which plunged in value after Lehman’s Sept. 15 bankruptcy. The disclosure was held up after the HKMA sought to keep some of its findings private and follows almost daily street protests by elderly investors who claim that banks had said the securities were low-risk. A total of HK$13.9 billion ($1.8 billion) of the credit-linked notes arranged by a local unit of Lehman were sold to Hong Kong individuals, according to the Securities and Futures Commission.

"If more restrictions are placed on the sale of investment products it could add a lot onto banks’ operating costs," said Paul Lee, an analyst at Hong Kong-based Tai Fook Securities Ltd. "Customers may also be more reluctant to invest because of all the extra documents they have to go through." The central bank identified 102 cases where complex and risky investments were sold by banks to "vulnerable" investors, according to information contained in the blacked-out section of the HKMA report made public at a hearing in the city’s Legislative Council today. Some investors have alleged that banks and brokerages misrepresented the potential risks when selling the notes. "What’s important right now is what the HKMA is preparing to do to help investors get their money back," said Chim Pui- chung, a legislator representing the financial services industry. "So far they haven’t offered much on this part."

The central bank had previously refused to disclose parts of its findings, arguing that it would be "against public interest." It later agreed to reveal in closed meetings deleted parts of the report to legislators. Sun Hung Kai & Co., the city’s biggest local brokerage by market value, in February agreed to pay back investors in the notes, making it the first vendor to decide to provide a full refund. It didn’t admit to any liability or wrongdoing in selling the products. BOC Hong Kong Ltd., Bank of East Asia Ltd., Wing Hang Bank Ltd. and Dah Sing Banking Group Ltd. were among the 19 firms that sold the notes, according to the Hong Kong Association of Banks.

Senate Banking Committee Chairman Christopher Dodd, D-Ct., said Monday there may be a need for Congress to investigate allegations made by Bank of American Corp. Chairman Ken Lewis last week regarding the bank's transaction to acquire Merrill Lynch. Dodd said that his staff were still looking into the matter, but that it may be necessary to convene hearings into the matter. Sen. Richard Shelby, R-Ala., the ranking Republican on the panel, called for hearings last week. Dodd said that he had been in touch with New York State Attorney General Andrew Cuomo, who made public the allegations by Lewis. Lewis testified before Cuomo under oath in February that former Treasury Secretary Henry J. Paulson and Federal Reserve Chairman Ben Bernanke pressured him to stay silent to Bank of America shareholders about the details of the transaction.

Those details included the fact that Lewis knew that the financial situation at Merrill Lynch was becoming increasingly tenuous. Merrill eventually took a $15.84 billion hit during the fourth quarter as Bank of America concluded its acquisition of the company. Normally executives are required to disclose any material information to shareholders regarding potential transactions. According to the testimony, first reported by the Wall Street Journal last week, Lewis said federal regulators urged him to stay quiet about Merrill. They were determined not to let a major financial institution fail, said the testimony.

As Treasury Secretary, Tim Geithner's public image has generally seemed "not quite ready for prime time." But his PR acumen as president of the New York Fed was in large part credited for landing him the job -- and now we know why. Geithner made one-on-one coffee dates, luncheons, tennis games, dinners and conference calls with reporters a major part of his job at the New York Fed, from the looks of the official schedule posted this morning by the New York Times. In addition to regular press briefings, backgrounders and whatever Geithner slipped in on his own time, Geithner scheduled one-on-one time for more than 68 journalists from 2007 to 2008, including twelve from the New York Times, ten from the Wall Street Journal and eight from the Financial Times. His favorite journalist by far appears to be Krishna Guha, an editorial page writer at the Financial Times, to whom he granted 12 interviews.

The Journal's Jon Hilsenrath and David Wessel, the FT's Gillian Tett and Chrystia Freedland and House of Cards author William Cohan also make a lot of appearances on Geithner's schedule, in addition to professional pundits Fareed Zakariah and Tom Friedman. What's particularly striking about Geithner's media schedule is how willing he seemed to be to speak individually with multiple reporters from the same media outlet: some days he would speak separately with three different FT journalists. As the Times has pointed out, Geithner wasn't necessarily satisfied with his press; the schedule shows three meetings with a publicist who represents Citigroup, and a few others with New York PR patriarch Howard Rubenstein.

Other regulars on Geithner's schedule: Ben Bernanke; the Kissinger clan, with whom Geithner seemed to be endlessly dining in 2007 and 2008; former New York Fed Chief and Goldman Sachs managing director Gerald Corrigan and Pete Peterson, the Blackstone Group co-founder who recruited Geithner to the position; the usual suspects from Citigroup, which tried to poach Geithner from his spot in 2007; Josh Steiner, the business partner of embattled car czar Steve Rattner; a hairstylist (or salon?) named Felix and real estate magnate Jerry Speyer of the Tishman-Speyer property behemoth, who chairs the board of the New York Fed. Speyer shows up 20 times on the schedule -- most likely in part because of the massive Fannie and Freddie-backed deal Tishman and Lehman Brothers inked in 2007 to buy the Archstone-Smith luxury apartment portfolio -- one of the deals that would later lead to Lehman's demise.

Perhaps equally telling is who doesn't show up on Geithner's schedule. His predecessor in the post, Bill McDonough, only seems to have met with him twice; same goes for Sheila Bair, the FDIC chairman Geithner is said to dislike, who doesn't make an appearance until October. Former Fed chairmen Alan Greenspan and Paul Volcker and former Treasury secretaries Larry Summers and Bob Rubin show up, of course, as does Paulson's predecessor John Snow, who represents the hedge fund and Chrysler parent company Cerberus -- but Paul O'Neill, who served during the accounting scandals that foreshadowed the current disaster and is perhaps the most intellectually honest man to hold the post in the past few decades, never does. O'Neill, of course, was unceremoniously sacked by an administration that eventually came to see him as a PR liability. He probably has a few words of counsel for Tim Geithner right now.

The New York Times was kind to post a big PDF of Tim Geithner's schedule from when he was head of the Federal Reserve Bank of New York, and I spent most of the morning wandering through it for items of interest. I've put some raw quantitative data -- who did he meet with, and how often? -- after the jump. But the most interesting detail, in a way, is the dog that didn't bark: I can't find any mentions of Barack Obama, or Joe Biden, or transition head John Podesta in the entire schedule.

There are a few scant references to meetings at the transition office -- about a half dozen in December and January -- but as far as I can tell there is no contact with the campaign or the president-elect before that, and no specific mentions of the president-elect at all. (The calendar runs from January 2, 2007 to January 11, 2009.) And since Geithner's November 4 schedule is packed from 7.30am to 7.15pm, I doubt the man had time to vote. Other than that, there were, by my count:

Fourteen meetings* with former Citigroup CEO Sandford Weill, who reportedly approached Geithner about becoming CEO of Citigroup himself. (Many of these meetings are private lunches.)

Twelve meetings with Morgan Stanley CEO John Mack.

Nine meetings with Goldman CEO Lloyd Blankfein.

Eight meetings with former NYSE president and former Merrill Lynch CEO John Thain.

Seven meetings with JP Morgan CEO Jamie Dimon.

Seven meetings with former Lehman Brothers CEO Dick Fuld.

Seven meetings with Citigroup CEO Vikram Pandit.

Five meetings former Treasury Secretary and former Citigroup Chairman Robert Rubin.

Five meetings with AIG CEO Edward Liddy.

Three meetings with former AIG CEO Robert Willumstad.

One "drink w/ Larry Summers." (Notable only because there is otherwise very little drinking on the schedule, and relatively little Larry Summers.)

One tennis match with Alan Greenspan.

One tennis match with two others and an unnamed "tennis pro"

One listing of "Table Tennis Finals." (No word on whether Geithner was playing, or won.)

* I use "meetings" pretty broadly -- it incorporates everything from a conference call, to a reception dinner, to an intimate lunch. And I am totally open to the possibility that my count is wrong. The PDF repeats some calendar pages, and there are a lot of pages.

Berkshire Hathaway Inc. shareholders have a chance this year to do something that’s rare among the Sage of Omaha’s followers: count their losses. Despite Berkshire’s reputation as a bear market bulwark, its stock has been walloped. The Class A shares are down 31 percent since September, to $90,000 as of yesterday, exceeding the 26 percent drop in the Standard & Poor’s 500 Index. One reason: Chief Executive Officer Warren Buffett’s increasing use of derivatives -- contracts whose value is based on the performance of stocks or bonds or the outcome of a specific event. That Buffett once called derivatives "time bombs" doesn’t calm investors.

Berkshire held contracts with a combined notional value of $67.3 billion at year-end. While this figure is used mostly for reporting purposes and isn’t indicative of potential losses, it dwarfs the company’s $25.5 billion in cash. Buffett himself has warned of an increasing possibility he might have a loss from one type of contract on Berkshire’s books. Fitch Ratings and Moody’s Investors Service have lowered their credit ratings on Berkshire, partly because of the derivatives. "People have become uncomfortable with financial investments that they don’t understand, especially anything related to derivatives," says Charles Bobrinskoy, a manager at Ariel Investments LLC in Chicago.

Berkshire’s derivatives fall into four categories. Because they carry the greatest notional value, at $37.1 billion, most attention is on put options that Buffett sold on stock indexes in the U.S., U.K., euro zone and Japan that expire from September 2019 to January 2028. Berkshire has to pay at expiration if any of the indexes are lower than they were when the puts were written. While analysis of these bets shows big losses are unlikely, Buffett, 78, hasn’t provided sufficient information on the derivatives to keep some investors from hitting the sell button. Bobrinskoy says he hasn’t been scared away: Of the $250 million he co-manages at Ariel, 5.6 percent was invested in Berkshire as of March 31. To lose the full $37.1 billion on the equity puts, the indexes would have to fall to zero -- an unlikely event. Berkshire received $4.9 billion in premiums, which together with what the company earns on it, may offset any eventual payments.

Citigroup Inc. analyst Joshua Shanker in a March 16 report examined several scenarios to gauge the likelihood of Buffett’s losing money on the puts. Using the S&P 500 as a proxy for all the indexes and assuming a 5 percent annualized return on the premium, the market would have to suffer a cumulative decline of at least 32 percent across the 15- to 20-year life of the contracts for the seller to lose money. In the U.S. market back to 1800, the only way to do that would be to start the bet just prior to the 1929 crash. Some economists compare today with the Great Depression, and some of the puts may have been written near the U.S. market’s all-time high in late 2007, according to information Buffett has disclosed. The S&P 500 in March was down 57 percent from its peak.

With that in mind, Shanker looked at scenarios that begin with a 50 percent drop in the S&P 500. From that nadir, if the index rose 6 percent annualized over 14 years, Buffett still would not owe any money when the puts expire -- even without consideration of the $4.9 billion in premiums. Shanker also sketched out grimmer scenarios. Starting with the 50 percent decline, if the S&P 500 rises at the stock market’s post-1800 average annual rate of 2.8 percent, Berkshire could be out $5.4 billion at the end of the bet. That assumes an initial one-third loss on the premiums followed by 2.5 percent annualized returns. David Winters says losses from these derivatives are unlikely. His Wintergreen Fund had 6.6 percent of its assets in Berkshire, as of year end. "We’re living in a world where there’s so much negativity, investors are extrapolating something that’s just remotely possible into something that’s probable," he says.

Berkshire hasn’t disclosed sufficient information to fully analyze its other derivatives, Shanker says. One category is simply municipal bond insurance structured as derivatives; the risks here are similar to those for his municipal bond insurer. Another type consists of credit-default swaps through which Berkshire guarantees payment of individual corporate bonds. Those bets were relatively small, totaling $3.9 billion in notional value at the end of last year. The final category is the most worrisome, Shanker says. Berkshire has sold contracts that require it to pay when credit losses occur at companies that are included in certain unnamed high-yield-bond indexes.

The notional value is $7.9 billion. Berkshire took in $3.4 billion in premiums on these contracts and has paid losses of $542 million. The company has also recognized a noncash, $3 billion mark-to-market loss. With these contracts, payments are made when a credit event occurs. They expire from September of this year to December 2013. Losses on these contracts are accelerating as bankruptcies grow, Buffett said in his shareholder letter in February. "Now with the recession deepening at a rapid rate, the possibility of an eventual loss has increased," he wrote. Buffett didn’t respond to an e-mailed request for comment. He is scheduled to address shareholders at Berkshire’s annual meeting on May 2, and quarterly results are expected from the company on May 1.

Mark Curnin, co-founder of White River Capital LP, an investment partnership that specializes in financial stocks, says Buffett’s derivatives are simply smart ways to do what he’s always done: underwrite insurance and buy attractive securities. "Buffett has handpicked a select group of risks that he understands and thinks are attractively priced," he says. The derivative risks are similar to the other hazards that might worry any investor in Berkshire. There are volatile profits from its insurance subsidiaries, for example, and units that depend on the housing industry, such as Acme Building Brands and Clayton Homes Inc. Then there’s Buffett’s portfolio of equity investments: While easy to understand, 7 of the 14 largest holdings listed at year-end were carried at a loss.

New York City's net personal income tax revenues plunged 51 percent in the first 24 days of April, compared with the same period a year ago, the city comptroller's office said on Monday. New York City's economy has been hurt by the devastation of Wall Street, its largest hometown industry, following the collapse last September of Lehman Brothers Holdings and a series of bank mergers amid the credit crisis. In the month of March alone, for instance, Wall Street shed 3,100 employees, according to the state's Department of Labor. U.S. states and cities, just like the federal government, usually see tax revenues surge in April because the month includes the April 15th annual tax deadline.

New York City often pays out more in refunds than it collects in taxes during April. But "through April 24, payments were running 33.5 percent below those of April 2008, and refunds paid out were running 21.8 percent below those of April 2008," said a spokesman for Democratic City Comptroller William Thompson. The state's economy rests on the city's shoulders because the city's financial sector pays about 20 percent of the state taxes. New York City is equally dependent on the financial sector, with economists saying that each high-paying Wall Street job creates service-sector employment ranging from one to three workers in a broad range of businesses from law firms to clothing stores and little gift shops.

Though the city's real estate market fended off much of the pain seen around the nation until late last year, the depth of its current fall was underscored by the state's mass transit agency. "We're seeing it declining even faster and deeper than in the post-1987 deflating of the real estate bubble," said Gary Dellaverson, chief financial officer for the Metropolitan Transportation Authority, at a finance committee meeeting. On Oct. 19, 1987, the Dow Jones industrial average .DJI lost 22.6 percent in the largest one-day percentage decline in stock market history. Afterwards, thousands of Wall Street jobs were lost and some never returned.

Democratic Governor David Paterson, speaking to reporters, estimated the state's deficit next year at $2.7 billion. The state will update its financial plan later this week, he said. New York City also should issue new estimates soon. While there was a "significant" drop in state corporate tax revenues in March, followed by a decline in personal income tax collections in April, Paterson added that there were signs the economy might stabilize sooner than anticipated. "However, there seems to be a projection later in the year that things may not be as bad as we first thought that they would be." The state's current budget cut the three-year deficit to about $11 billion from $16 billion, Paterson added.

The International Monetary Fund (IMF) deserves credit, figuratively speaking, for cleverly manipulating the financial troubles of emerging and low-income nations to procure a fresh infusion of capital for itself. But its tactics at this month's G-20 summit in London -- where President Barack Obama signed off on tripling the IMF's lending resources -- should not hoodwink anyone, least of all American taxpayers who pay the largest share of IMF expenses. Lost in the lofty talk about putting the IMF in the center of world economic recovery is the fact that the organization has been quietly attempting to ensure its own survival by seeking permission to engage in gold sales. While IMF officials insinuate the receipts would be used to help poor countries, the real goal is to set up a permanent endowment fund for the IMF.

The U.S. should not replenish the coffers of a multilateral bureaucracy that quite literally lost its reason for being on Aug. 15, 1971 -- the day President Richard Nixon "closed the gold window" and brought an end to the Bretton Woods agreement, which allowed countries to convert their dollar holdings, via the IMF, into gold at a fixed price. Instead, Congress should call for the IMF's dismantlement and restitution of its assets. The most solid asset owned by the IMF, purely as a legacy of its original incarnation, is gold. The IMF holds 3,217 metric tons (103.4 million ounces) of gold, which makes it the world's third largest official holder. Actually, it's a misnomer to say the IMF "owns" the gold since the bullion belongs, according to the IMF articles of agreement adopted at Bretton Woods in 1944, to its member nations.

Nevertheless, the IMF is now seeking to sell a considerable chunk of those gold holdings -- some 12.9 million ounces -- which it insists are exempt from restitution to members in the event of IMF liquidation. Its reason? Between December 1999 and April 2000, to fund its Heavily Indebted Poor Countries (HIPC) initiative, the IMF arranged to sell gold which it held on its books at a price of roughly $50 to two member countries, Brazil and Mexico, at the market price of $355. It put the profits of close to $4 billion in a special HIPC account; simultaneously, the IMF accepted back the gold sold to Brazil and Mexico in settlement of their financial obligations of that amount.

Bottom line: The balance of IMF holdings of physical gold was left unchanged, although it raked in the substantial difference between the gold's market price and its book value. The IMF asserts a propriety claim over the 12.9 million ounces it "acquired" through these transactions. Unfortunately, artful accounting -- from the deceptive practice of carrying gold at its former official price (about $52) rather than its current market value (about $914), to the arcane usage of an intangible monetary unit called a Special Drawing Right (SDR) -- has become the IMF's defining characteristic.

The IMF once served as administrator for the gold-anchored Bretton Woods system of fixed exchange rates among currencies. It now stands for laxity, for endless government fixes, for ineptitude and political compromise. The IMF preaches budgetary discipline one moment, only to abandon it under pressure from the current crop of presidents, prime ministers and potentates who authorize its spending. Now the IMF is attempting an end-run around the U.S. Congress, as it quietly moves toward selling gold, most likely to China. Why does the IMF need the money? Just three years ago, the bloated organization (half of its 2,600 staff are economists) was nearly defunct; headquartered in Washington, D.C., the IMF was desperate to create an endowment fund to provide for its continued existence.

But in 2007, a specially convened committee of "eminent persons" helpfully suggested that if the IMF could sell those 12.9 million ounces of gold and set up a trust fund with the windfall profits, the investment returns could plug the gap between its administrative expenditures and the amount it earns as an intermediary that channels funds from rich countries to poor countries. Sound familiar? Only one problem: IMF gold sales must be approved by an 85% voting majority of its members. The U.S. has a 17% vote; thus, the IMF cannot sell gold without the explicit consent of Congress. But Rep. Barney Frank (D., Mass.), who chairs the House Financial Services Committee, has indicated his openness to approving IMF gold sales -- conditional that some of the receipts be used to "help finance debt relief for poor countries."

Ah yes, it is always about helping the poor. Which is why the IMF emphasized its willingness to assist "poor countries" in its carefully calibrated request for additional resources from G-20 nations. Not surprisingly, the London stratagem proved successful. It was readily embraced by G-20 leaders eager to demonstrate how much they care about the human consequences of economic meltdown. Ironically, the IMF has been widely blamed by recipient nations in Africa and Latin America for perpetuating poverty. Excessive transfers to less-developed countries have the perverse effect of suppressing the entrepreneurial reserves of citizens. It is only when nations manage to get off the global dole that they are taken seriously by global capital markets and can start to achieve bankable growth.

The IMF has shown an uncanny ability to transmogrify into whatever politically acceptable form necessary to ensure its survival. Throughout the intervening decades since the end of Bretton Woods, the IMF has scrambled to redefine itself as (in rough chronological order): a global debt-collection agency, an economic-research organization, a referee for financial disputes among the Group of Seven leading industrialized nations, and a front to permit Western nations to avoid being blamed for problems arising in the transition to democratic capitalism for formerly communist nations.

In its latest manifestation as global financial surveillance monitor and G-20 sidekick, the IMF has taken to delivering somber pronouncements about the world economic outlook, concluding in mid-April: "The current recessions are likely to be unusually severe, and the forthcoming recoveries sluggish." And what does the IMF recommend? "Aggressive monetary and, particularly, fiscal policies could strengthen and bring forward recoveries." This sage advice conveniently dovetails with the agenda of Mr. Obama, who, as mentioned earlier, agreed to tripling the IMF's lending resources at the London summit. And to remain au courant with British Prime Minister Gordon Brown, IMF chief Dominique Strauss-Kahn has also called for expanding "the regulatory perimeter to encompass all activities that pose economy-wide risks."

Zhou Xiaochuan, China's powerful central banker, has authored a proposal for international monetary reform that would replace the dollar with "a super-sovereign reserve currency managed by a global institution." Citing "the inherent deficiencies caused by using credit-based national currencies," he suggests the SDR could assume this role. In the view of Mr. Zhou, the way to enhance international monetary and financial stability is to have member countries gradually entrust their reserves "to the centralized management of the IMF." Before anyone gives any credence to the notion of having the IMF take on the task of issuing a new global currency, however, we need to remember that the original Bretton Woods system worked precisely because the dollar was convertible into gold at a fixed price. And gold is real money. Congress should just say no.

International Monetary Fund officials were nearly giddy in early April when they learned that leaders at the G-20 summit backed a fourfold increase in fund resources to $1 trillion. During a press briefing, IMF Managing Director Dominique Strauss-Kahn used the phrase "the IMF is back" six times. But at the IMF's spring meeting this past weekend, reality set in. In exchange for the money, the IMF has been handed tough assignments in fighting the global recession and staving off another one. The work will require a political dexterity and willingness to stand up to powerful IMF members that the fund has rarely shown in the past. "There's been a huge expansion of IMF resources and huge attention to the IMF, but nothing has been done to make members fear IMF surveillance" or oversight, says Adam Posen, deputy director of the Peterson Institute for International Economics, a Washington think tank.

About $500 billion of the new funds are earmarked for the IMF's main job of bailing out troubled countries. The IMF has introduced a credit line that doesn't require borrowers to make the kinds of painful economic changes -- cutting spending, slashing subsidies -- that have turned the IMF into political poison in much of Latin America and Asia. Mexico, Poland and Colombia have signed up for the credit line. The new facility has won plaudits from some developing countries, but the IMF will still have to make tough political calls. Only nations ranked highly by the IMF can qualify for credit line. The IMF often forces other borrowers to cut spending or raise interest rates even if that deepens a downturn, though the IMF has taken steps to protect some programs for the poor. The disparate treatment has prompted complaints in Turkey, Pakistan, Eastern Europe and elsewhere that the IMF is playing favorites, and it may lead to pressure on the fund to ease its standards. The World Bank has tried to reduce the effect of the budget cuts by financing infrastructure projects that otherwise might be jettisoned.

Pressure on the IMF will ramp up when it must decide whether to renew the credit lines after their one-year terms. Saying "no" would undermine a country's economic standing; saying "yes," if the country's policies don't warrant it, would undermine IMF credibility. "Countries that have these facilities would be well advised not to use them," said Montek Singh Ahluwalia, deputy chairman of India's planning commission and a former IMF official. That way countries can boast that IMF credit lines give them extra resources, but they wouldn't become too dependent on fund money. The IMF is also taking on a politically fraught new assignment: providing early warnings of problems that could explode into another crisis. IMF economists are examining which economic indicators signal asset bubbles are forming, and they are assessing how political or economic decisions in one part of the world could produce problems elsewhere.

The fund is now conducting what it calls a "dry run" of the system, which it plans to have working by the IMF's fall meeting in Istanbul in October. "The IMF is trying to assess vulnerabilities across [financial] instruments, across borders and across industries," said Egyptian Finance Minister Youssef Boutros-Ghali, who heads the top IMF advisory board. Some nations worry that the IMF will mistakenly diagnose potential problems, forcing countries to choose between ignoring the warning or adopting policies the IMF suggests, which could choke off economic growth. "If you cry wolf once and the wolf doesn't show up, it will cost people a lot of money," Mr. Boutros-Ghali said. How will the IMF get its members to take its warnings seriously? Friday at the School of Advanced International Studies, Mr. Strauss-Kahn talked tough. "Early warnings must be strong, candid, credible and even-handed," he said. "They must not shy away from naming and shaming" -- citing specific countries -- "where appropriate."

But Mr. Strauss-Kahn didn't commit to making the early-warning exercises public, and staffers say they doubt the IMF will. Instead, the IMF economists plan to deliver the news to financial officials as part of private consultations -- the same formula that has led to IMF recommendations being ignored in the past. Last spring, the U.S. Treasury shelved an IMF plan to recapitalize banks without paying it much attention. Earlier this year, the European Union blew off an IMF proposal to have struggling Eastern European countries devalue their currencies and adopt the euro. In both cases news of the IMF proposals leaked to the media well after they could have made a difference if they had been well publicized. It may take public disclosure of the warnings to get the attention of policy makers and markets, especially in wealthy nations that don't rely on the IMF for loans.

Brazilian Finance Minister Guido Mantega says the old patterns may be breaking down because of the severity of the current global downturn, which started in the U.S., spread to Europe and then tanked developing countries. The rich countries realize they made many errors, he says, and will be more amenable to IMF advice even if it's made privately. "Even advanced countries will submit to oversight from these [international financial] institutions," he said. The U.S., for instance, has said it would ask the IMF to do a broad review of the U.S. financial system -- after years of avoiding such a review. If that's a precursor of a new attitude, the G-20 embrace of the IMF will have changed the global economic system perhaps even more than it expected to do.

For all the uncertainty swirling around General Motors, the troubled automaker said Monday that one thing was clear: it must become drastically smaller if it hopes to remain a viable company, regardless of whether it has to file for bankruptcy. G.M. said it would eliminate another 21,000 factory jobs, close 13 plants, cut its vast network of 6,500 dealers almost in half and shutter its Pontiac division. By the time it is finished, G.M. expects to have only 38,000 union workers and 34 factories left in the United States, compared with 395,000 workers in more than 150 plants at its peak employment in 1970.

One goal of this latest plan was to convince the Obama administration, which has been skeptical of G.M.’s previous restructuring goals, that the company is willing to take harsh measures and cut its bloated infrastructure to match its steadily declining share in the United States. Absent such steps, the government has said it is reluctant to lend the company more money. But for the first time since it toppled into financial crisis last year, G.M. appears to be earning government support. That might mean billions more in loans if the company’s stakeholders can come to an agreement before a deadline at the end of May. G.M. said on Monday that it needed to borrow $11.6 billion more, for a total of $27 billion. President Obama’s auto task force said Monday it had "made no final decision" on future investments in G.M., which is subsisting on $15.4 billion in federal loans. The task force, however, called the new plan an "important step in G.M.’s efforts to restructure its company."

This plan is a far cry from G.M.’s strategy of just a year ago, when it was waging a spirited battle with Toyota for the title of world’s largest automaker. Where once G.M. had a 50 percent share of the market for new vehicles in the United States, the company hopes to at least hang on to its current 18 percent share. Analysts warned that even those projections could be optimistic. "There is still a huge risk for market share losses beyond what the company is forecasting," said John Casesa, an industry consultant. G.M., however, still faces difficult odds of restructuring outside of bankruptcy court.

The company is still negotiating with the United Automobile Workers union. The government wants the union to accept company stock to finance half of G.M.’s $20 billion obligation for retiree health care. The U.A.W. this weekend agreed to a similar health care deal with Chrysler, which has borrowed $4 billion from the government and hopes to get $6 billion more. The union’s new retiree health care trust would own a majority stake in Chrysler in exchange for helping the carmaker save $4.5 billion. A summary given to union leaders said Fiat would ultimately own 35 percent and that 10 percent would be held by the government and Chrysler’s lenders, two people with direct knowledge of the deal said. Chrysler would give the union a 55 percent stake to cut its obligations to the health care trust in half, said these people, who spoke on condition of anonymity because details of the agreement have not been released publicly.

The deal suspends cost-of-living pay increases, limits overtime pay and reduces paid time off. It also eliminates dental and vision benefits for retirees. It also provides for Fiat to begin building cars in at least one Chrysler plant. G.M., however, will have more trouble winning over its bondholders. The company, after consulting with Treasury officials, offered on Monday to give the holders of $27 billion in unsecured debt 225 shares in G.M. stock for every $1,000 in debt. G.M. said it would have to file for Chapter 11 bankruptcy protection unless 90 percent of the vast bondholder group accepted the terms by June 1. "I can’t imagine that this is going to go through," Shelly Lombard, a bond analyst with the firm Gimme Credit, said. "This is not an olive branch to come back to the table. This is basically a sledgehammer. Having said that, I’m not sure that bondholders have a lot of other options."

Fritz Henderson, G.M.’s chief executive, also expressed doubts that enough bondholders would take the offer. Even if they do not, which would push the company into bankruptcy, he said he expected the company to pursue its restructuring. "If it can’t be done outside a bankruptcy, we’ll do it in a bankruptcy," he said. If bondholders approve the debt-for-equity exchange, they would own about 10 percent of G.M., making them a minority shareholder in a company controlled by the Treasury and the U.A.W.’s retiree trust. According to the offer, the Treasury would own at least 50 percent of G.M. in exchange for forgiving about $10 billion in federal loans. The union trust, in turn, would receive a stake of about 39 percent. A committee of big G.M. bondholders on Monday called the offer a "a blatant disregard for fairness for the bondholders" and an example of "political favoritism" toward the U.A.W. "The current offer is neither reasonable nor adequate," the committee said.

Representative Thaddeus McCotter, a Michigan Republican, is concerned that some bondholders want the company to go bankrupt because they also hold credit-default swaps insuring them against losses. He is urging the Treasury secretary, Timothy F. Geithner, to disclose which G.M. bondholders have default swaps from the American International Group, the insurance company that was bailed out by the government. "It would be unconscionable to use taxpayer money to help people benefit from the bankruptcy of General Motors," Mr. McCotter said. Several industry analysts said the bondholder offer appeared destined to fail. "Unless the offer is revised before May 8, G.M. could potentially file for Chapter 11 protection by the end of next month," Brian Johnson, of Barclays Capital, wrote in a note to clients.

Many dealers said they were stunned by how quickly G.M. wanted to eliminate more than 2,600 showrooms. "This is just too rapid, and I think it’s going to create a disorderly shutdown of a lot of stores," said John McEleney, chairman of the National Automobile Dealers Association. "In the short term, they’re likely to lose sales, which is counterproductive to G.M.’s recovery." Senator Carl Levin, a Democrat from Michigan, said he received assurances from the task force late Monday that protecting jobs would be a high priority as it evaluated G.M.’s new plan. "The depth of the pain inflicted on our workers, families and communities by these decisions should not be minimized," Mr. Levin said. "It appears G.M. was left no choice, and I now believe bondholders have no choice, either, but to accept significant losses as a better alternative to bankruptcy."

General Motors is moving faster to remake itself with decisions to ax Pontiac, thin its huge herd of car dealers, and cut more plants and workers. But the company still needs its bondholders to cash in $27 billion in debt for stock to avoid bankruptcy. That won't be easy. GM wants its bondholders to take 225 new shares of the company for every $1,000 in bond value. GM will also pay the interest. That adds up to at most 5¢ on the dollar for the debt, says Barclays analyst Brian Johnson. That's what could make it a tough sell. The Treasury Dept. will also be offered 50% of GM's stock in exchange for erasing half of the $20 billion in government debt GM will have accrued as of June 1. The government will also get stock. GM also plans to give the United Auto Workers 50% of the value of $20 billion owed to the union's retiree health-care trust in cash and the rest in stock. So the bondholders are being offered a lot less.

GM hopes that at least 90% of the bondholders will accept the deal so the company can reduce its total debt down to $48 billion. But the company will have to convince bondholders that the deal is better than fighting for more in bankruptcy court. "This is not something the bondholders will be inclined to accept," says Johnson. "If you don't take their offer, you may be able to do better." If bondholders refuse the offer, they will be betting that they can get more than 5¢ on the dollar in cash from a bankruptcy judge. Since bondholders stand on equal footing in bankruptcy court as unsecured creditors along with the United Auto Workers, they may figure that the judge will give them some of the stock or cash that GM plans to give the UAW.

There is one other catch. Some bondholders own credit default swaps, which amount to an insurance policy on GM bonds that pay in full if the company goes bankrupt. Tim Backshall of Credit Derivatives Research says that there are contracts backing an estimated $2.7 billion in bonds on the market. If those contract holders all hold bonds, it won't take too many more bondholders to refuse the deal and send GM to bankruptcy. Treasury wants GM to get enough buy-in to wipe away $24 billion of the $27 billion in debt, said GM CEO Frederick A. "Fritz" Henderson. "If we fall short, we will fall into a bankruptcy process," Henderson said. If the bond exchange goes through and the UAW and Treasury agree to the deal, the government and union will collectively own 89% of GM. The government would own about half of the company. The current stockholders will be diluted down to 1% of the company.

Already the offer is getting pushback. An ad hoc committee representing owners of about $6 billion in bonds—and which has dialog with owners of another $6 billion—issued a statement saying that its members are, "deeply concerned with today's decision by GM and the auto task force to offer only a small, inequitable percentage of stock to its bondholders." The committee griped that the union's healthcare trust is getting 50% of its $20 billion GM debt in cash and 39% of GM's stock while the bondholders, who have the same legal standing as the union, are being offered a 10% stake in GM and almost no cash. GM does have some limited options to change the debt-for-equity offer. But under the terms disclosed so far, the company is offering so much equity to the government and the union's healthcare trust that it would be tough to make the offer substantially sweeter than it is.

The good news is that if GM avoids bankruptcy or makes it out of court, the company will be seriously restructured. Henderson said GM will be sized to break even in a market selling 10 million cars, but at current market share levels of around 19%. That means GM needs to hold market share or see sales rebound, but it stands a much better chance of making money than it has since the company needed a U.S. market selling at least 16 million vehicles a year. "When the market improves—and it will improve—we can be very successful," Henderson said. Last year, the company lost $31 billion when sales fell to 13.2 million vehicles. So far this year, American consumers are on pace to buy less than 10 million. But for the government to get paid back, GM would need to post earnings before interest and taxes of about $16 billion, says Johnson.

That's more than any of the projections from GM's recovery plan. Plus, GM will still have a lot of debt. Henderson said in an interview that with the restructuring and a rebound in the car market, GM can start paying down its debt and get its borrowing more in line with other successful industrial companies. But it may take through 2014 to get there. With the closure or sale of other brands including Saturn, Hummer, and Saab, GM will go forward with four brands, Chevrolet, Cadillac, Buick, and GMC, Henderson said. By closing Pontiac and ditching Saab, Hummer, and Saturn, GM will have 34 cars, 13 fewer than its February plan included. Next up, GM has to get a lot of dealers to go away. Henderson said he will slash GM's dealership count by 42% from 2008 to 2010, from 6,246 to 3,605. The company will offer those dealers some kind of compensation, but hasn't determined how much, says Mark LaNeve, GM's vice-president for North American sales and marketing. "We have been overdealered for years," LaNeve said.

Cutting dealers could be costly, but GM might be able to negotiate cheaper buyouts than it did with Oldsmobile in 2000. Faced with bankruptcy, which would make it tough for dealers to get anything, they may take lower payouts. Henderson said GM will still have to pay to buy back parts and help exiting dealers sell off inventory. Henderson is also cutting more workers. GM said it would cut 21,000 U.S. factory jobs by next year, dropping its blue-collar workforce to 40,000 employees. Its total number of factories will shrink from 47 to 34, which is three fewer than GM planned to close in February.

Buyouts for workers still have to be negotiated with the UAW, Henderson said. But he added that the union has been cooperative. Will the cuts be enough? Henderson did say that GM needs to hold market share and vehicle pricing for it all to work in a poor market. That won't be easy. LaNeve said GM's retail market share has been stable, so GM may have bottomed out. But the company still needs a market rebound. And even more important, LaNeve says, GM will have to burnish its image: "Eventually, we'll get a strong message out there that we really have reinvented GM."

The government could be exposed to a host of conflicts and potential unintended consequences if it ends up -- as now appears likely -- with a controlling stake in General Motors Corp.Under GM's latest restructuring plan, the U.S. would get at least a 50% stake in the largest Detroit auto maker. Even without a majority stake, the government was able to use its muscle in March to oust GM Chief Executive Rick Wagoner. But such a major holding would turn GM into a sort of Government Motors, making the federal government the company's de facto boss and bank lender. A direct stake could create other uncomfortable conflicts: The Obama administration would be setting emissions and mileage standards for cars in Washington while having to implement them in Detroit. It also would make the government a direct partner of the United Auto Workers, which would get a 39% stake in the company under GM's latest blueprint for survival.

A final GM plan is still many months away, and early reaction from bondholders suggests that the plan won't come together in its current form. But even if it flops, the proposal reveals that the government, in close consultation with GM, is prepared to become more deeply immersed in the operations and rehabilitation of the auto maker. Both the Bush and Obama administrations have grappled with how to shore up the economy without getting directly involved in running companies. They were unable to avoid an entanglement with insurer American International Group Inc., in which the government now owns an 80% stake after committing more than $170 billion in emergency relief. It will soon own more than a third of banking giant Citigroup Inc., with which it has had a sometimes-fraught relationship.

But in contrast with those cases, the GM proposal comes as part of an all-out administration effort to restructure the U.S. auto industry, including the country's third-largest car company, Chrysler LLC. "The big question is whether the government, as a shareholder, will be focused on GM making money, or it making clean and green cars, or whatever other political agenda they have for the auto space," says Peter Kaufman, president and head of restructuring at investment bank Gordian Group LLC. Administration officials dismissed suggestions that they were preparing to nationalize GM, saying that the plan put forward Monday was preliminary. "We're supportive of this offer and of this process, but no final decisions have been made," said one administration official. Another official said the administration has long planned to swap the government's debt holdings in GM for a large equity stake, but has no intentions of running the company.

Under the GM proposal to bondholders, the government would forgive $10 billion in loans to the company in return for a 50% stake, while GM's tens of thousands of public bondholders would be asked to surrender around $24 billion in bond debt for a 10% stake. GM continues to pursue two tracks for its turnaround -- one outside bankruptcy court and one inside. One person involved in the situation says a late-May Chapter 11 bankruptcy filing by GM is "99% likely now, maybe higher." In either case, the government would be in a position to set policy for the company. GM is one of the largest sellers of full-size trucks and sport-utility vehicles in the world, vehicles that are notorious for fuel inefficiency. Yet such products, which include the Chevy Silverado pick-up and Cadillac Escalade SUV, have always been among the company's most profitable. That could present the government with a painful trade-off.

Even after its restructuring, GM is expected to remain one of the country's largest employers of unionized workers, and it also does business with thousands of union and non-union employers. That raises such questions as whether the government would allow GM to buy parts from a supplier that has resisted organizing efforts by the UAW or other labor unions, or whether it would encourage suppliers to support UAW organizing efforts -- as GM had done for several years at the union's urging. The Treasury's current plan is to hold its GM ownership stake in some form of trust, say people briefed on the situation. The administration's auto team is now drafting documents that lay out how that trust and its government-appointed trustees will manage the government's majority stake.

Still unclear is how long the government would maintain its ownership, these people say. There are differing views in the administration, with some advocating a quick sale of the stake while others argue the government needs to take a long-term view and hold GM for a long time to get a better price. One administration official said the government would likely sell its shares gradually, but only after GM had regained its financial moorings and rebuilt its reputation. "This ownership thing is a few-year process, three years maybe, until auto sales come back," said one person familiar with the matter. How and when to sell GM and whether to consider private-equity firms or foreign auto makers as potential buyers presents another set of complications. People familiar with the situation say that for now the government appears to have decided not to solicit buyers for equity stakes in a new GM, because it doesn't have all the information investors would want before making what would likely be a multibillion-dollar commitment.

The government is still formulating financial projections and a capital structure for the new GM, which would be slimmed down to just a few brands—most likely Chevrolet, Cadillac, Buick and possibly GMC, as a niche truck brand, these people say. They say documents circulating in Washington show a radically smaller GM. "Investing in GM would involve a couple billion dollars, which is obviously not an impulse buy, so you'd want to analyze it in depth," said investor Wilbur Ross, who owns a large auto-parts supplier called International Automotive Components. "I'd think at some price there'd be some interest, especially as you remove debt and combine" that with relief from retiree health-care obligations and real wage-and-benefit concessions. Economists point to the government's intervention in the U.S. railroad industry in the 1970s as the best corollary to what may now happen at GM. In that case, the government created the Consolidated Rail Corp. in 1976 to absorb rail lines from two bankruptcy carriers. The company was sold to private investors 11 years later.

Despite the automaker's many woes, GM executives say it's business-as-usual in China. Some industry watchers aren't so certain. Despite the auto giant's well-publicized problems at home, General Motors executives point hopefully to China as an example of a market where things are still going well. In March, GM had its best ever month in China, selling 137,004 vehicles. For the first three months of 2009, sales were up almost 17% compared with the same period a year earlier, spurred by minivan sales at its SAIC-GM-Wuling joint venture. And with signs of the Chinese economy picking up as the government's $586 billion stimulus package kicks in, GM expects to benefit as demand improves. "We think the market is going to be O.K. for the rest of the year," says Kevin Wale, president and managing director of GM China. "A lot of people are still aspiring to buy their first car in China."

At the Shanghai auto show, which closes on Apr. 28, other GM executives have been sounding upbeat about China, too. Like counterparts from other automakers, they have been making confident noises about the Chinese car market. While sales around the world sink, both Chinese and international carmakers agree that car sales in China will reach new heights in 2009. Indeed, in the first three months of the year, the country surpassed the U.S. as the world's biggest car market. At a press briefing last week, GM's Asia head, Nick Reilly, said the company planned to double sales in China to 2 million and launch 30 new or upgraded models in five years, consolidating its position as one of the leading foreign automakers in the Middle Kingdom. "We will continue to invest in new products for China, in new facilities, and the latest in technology," Reilly told reporters. "China remains a key market for GM." In another sign of confidence in its Chinese business, GM showed off at the Shanghai show a Buick minivan concept developed by the company's China-based engineers.

Still, there's one big question threatening the rosy outlook from GM executives. What happens to the company's China operations if the automaker, now in the midst of difficult negotiations with bondholders who own $28 billion in GM debt, ends up declaring bankruptcy? GM executives insist a bankruptcy would not affect the company's profitable China operations. "Generally, we will carry on doing our business as we're doing it today," says Wale. GM says its China business is financially self-sufficient and not reliant on Detroit for funding, while its partners have full confidence that the China business won't be hurt by a bankruptcy. "It is very important to understand that if there is a court-ordered restructuring, it is different than in some other countries," Wale says. "A company continues to trade and continues its business and can come out of it stronger than before." And with the Chinese market one of the few bright spots in global autos, analysts say, a bankrupt GM would be expected to do everything it could to maintain its China ambitions. "Even if GM goes bankrupt, there will be someone taking it over," says Zhang Xin, auto industry analyst at Guotai Junan Securities in Shanghai. "From what it looks like right now, I don't expect anyone would choose to give up on China."

Still, for all of GM's confidence, some industry watchers warn that bankruptcy in the U.S. would have a larger impact on business in China than the company is letting on. One problem, says Ashvin Chotai, managing director of Intelligence Automotive Asia, an automotive consultancy, is that no one really knows how a bankruptcy in the U.S. would play locally. "As far as I know, there has never been a bankruptcy at one of the foreign partners, so this [would be] a test case," he says. GM's local operations in Asia may be self-funding, but bondholders might also question how separate GM's China operations are from the parent. Despite its local partnerships, "GM China is not a standalone company; it still belongs to GM," Chotai says. "If I were a bondholder in GM, I would want some money out of China. The bondholders have funded a lot of the investment." GM's local joint-venture partners will certainly be watching events closely. In China, foreign automakers are required to have joint-venture agreements with local carmakers if they want to build and sell cars in China. In return, the foreign firms hand over knowhow and technology to partners. GM has a 50-50 partnership with Shanghai Automotive Industry Corp., which makes and sells Chevrolets, Buicks, and Cadillacs in China, and a one-third stake in SAIC-GM-Wuling. In the event of a GM bankruptcy, analysts say, the Chinese partners would want to know how a court-ordered restructuring would impact the flow of new models.

An additional complication could come from South Korea. The country is home to GM Daewoo Auto & Technology, which engineers popular China-made GM cars such as the Buick Excelle. Like its parent, GM's Korean subsidiary is facing financial difficulties; GM Daewoo exhausted credit lines in February and has asked the government-run Korea Development Bank and other creditors to provide fresh loans. However, its future is unlikely to be resolved before GM's. Asked if it's seeking assurances from GM, a spokesperson at SAIC didn't reply to e-mailed questions. But GM's Wale says that his confidence is shared by SAIC and other GM stakeholders. "We talk to our partners, the government, and employees," he says. "Obviously, people will ask questions, but they understand that the U.S. government is supporting General Motors through this process." Then, of course, there are the customers. While GM's 2009 sales so far are impressive, there are some important caveats. Sales are surging at SAIC-GM-Wuling but SAIC, rather than GM, has a controlling 51% stake in that venture. Out of GM's total March sales of 137,000, Wuling sold 90,950 commercial minivans and trucks, up 38% from a year earlier. GM's non-Wuling sales grew more slowly, rising 4.5%, to 46,220. In passenger cars, critics say GM is losing ground to Japanese rivals Toyota and Honda. And with China's auto buyers increasingly savvy, the negative publicity surrounding bankruptcy proceedings is unlikely to increase traffic at dealerships.

Milan’s financial police seized 476 million euros ($620 million) of assets belonging to UBS AG, Deutsche Bank AG, JPMorgan Chase & Co. and Depfa Bank Plc as part of a probe into an alleged fraud. The police froze the banks’ stakes in Italian companies, real estate assets and accounts, the financial police said in a statement today. The assets seized yesterday also include those of an ex-municipality official and a consultant, the police said. The City of Milan is suing the four banks after it lost money on derivatives it bought from the lenders in 2005. The securities swapped a fixed rate of interest on 1.7 billion euros of bonds for a variable rate. The city said it was losing 298 million euros on the securities as of June. Milan is among about 600 Italian municipalities that took out 1,000 derivatives contracts worth 35.5 billion euros in all, the Treasury said.

"Milan is an important case because it can be used as an example by others," said Alfonso Scarano, who is heading a study into the trades by AIAF, a group representing Italian financial analysts. "This is a unique time for borrowers to shed light on their potential losses and renegotiate contracts" to take advantage of interest rates that have fallen to record lows. AIAF will next week testify before the Italian Senate’s inquiry into the cities’ use of derivatives contracts. The banks reaped about 100 million euros in fees from the transactions, Milan’s financial police said today. The banks misled municipal officials on the advantages of buying the derivatives, including the impact of the fees they charged on the contracts, the financial police have said.

Public officials had turned to financial instruments to reduce the cost of their debt and help fund their budgets. Local governments often entered into derivative contracts without soliciting bids from competing buyers. The Milan case is among lawsuits filed by local governments from Germany to the U.S. amid allegations of mis-selling and fraud. Italy’s Senate is leading a review of the use of derivatives among local administrations. The U.S. Justice Department has been investigating for more than two years whether banks and brokers conspired to overcharge local governments on similar swap agreements. Alabama challenged a so-called swaption deal last year as local governments across the U.S. faced rising bills after derivative trades with Wall Street banks backfired.

The Federal Reserve has been hobbled by at least two major shortcomings that were primarily responsible for the current and several previous credit crises. Its failure to spot the importance of changing financial markets and its commitment to laisser faire economics were big mistakes and justify a fundamental overhaul of the Fed. The first of these shortcomings was its failure to recognize the significance for monetary policy of structural changes in the markets, changes that surfaced early in the postwar era. The Fed failed to grasp early on the significance of financial innovations that eased the creation of new credit. Perhaps the most far-reaching of these was the securitisation of hard-to-trade assets. This created the illusion that credit risk could be reduced if instruments became marketable.

Moreover, elaborate new techniques employed in securitisation (such as credit guarantees and insurance) blurred credit risks and raised – from my perspective, many years ago – the vexing question, "Who is the real guardian of credit?" Instead of addressing these issues, the Fed was highly supportive of securitisation. One of the Fed’s biggest blind spots has been its failure to recognise the problems that huge financial conglomerates would pose for financial stability – including their key role in the current debt overload. The Fed allowed the Glass-Steagall Act to succumb without appreciating the negative consequences of allowing investment and commercial banks to be put together. Within two decades or so, financial conglomerates have come to utterly dominate financial markets and financial behaviour. But monetary policymakers failed to recognise that these behemoths were honeycombed with conflicts of interest that interfered with effective credit allocation.

Nor did the Fed recognise the crucial role that the large financial conglomerates have played in changing the public’s perception of liquidity. Traditionally, liquidity was an asset-based concept. But this shifted to the liability side, as liquidity came to be virtually synonymous with easy borrowing. That would not have happened without the marketing efforts of large institutions. My second major concern about the conduct of monetary policy is the Fed’s prevailing economic libertarianism. At the heart of this economic dogma is the belief that markets know best and that those who compete well will prosper, while those who do not will fail.

How did this affect the Fed’s actions and behaviour? First, it explains to a large extent why the Fed did not strongly oppose the removal of Glass-Steagall restrictions. Second, it also helps explain why the Fed failed to recognise that abandoning Glass-Steagall created more institutions that were "too big to fail". Third, it diminished the supervisory role of the Fed, especially its direct responsibility to regulate bank holding companies. To be sure, the Fed’s supervisory responsibilities have never been very visible in the monetary policy decision-making process. But its tilt toward an economic libertarian approach pushed supervision a notch down just at a time when financial market complexity was on the rise. Fourth, as hands-on supervision slackened, quantitative risk modelling became increasingly acceptable. This approach, especially quantitative modelling to assess the safety of a financial institution, was far from adequate. But it worked hand in glove with a philosophy that markets knew best.

Fifth, adherence to economic libertarianism inhibited the Fed from using the bully pulpit or moral suasion to constrain market excesses. It is difficult to believe that recourse to moral suasion by a Fed chairman would be ineffective. Such public pronouncements about financial excesses are hard to ignore, reaching the broad public as well as market participants. Sixth, the Fed’s increasingly libertarian philosophy underpinned its view that it could not know how to recognise a credit bubble but knew what to do once a bubble burst. This is a philosophy plagued with fallacies. Credit bubbles can be detected in a number of ways, such as rapid growth of credit, very high price/earnings ratios and very narrow yield spreads between high- and low-quality debt. By guiding monetary policy in a libertarian direction, the Fed played a central role in creating a financial environment defined by excessive credit growth and unrestrained profit seeking. Major participants came to fear that if they failed to embrace the new world of securitised debt, proxy debt instruments, and quantitative risk analysis, they stood a very good chance of seeing their market shares shrink, top staff defect, and profits dwindle.

Ironically, the problem was made worse by the fact that the Fed was inconsistently libertarian. The central bank stuck to its hands-off approach during monetary expansion but abandoned it when constraint was necessary. And that, in turn, projected an unpredictable and inconsistent set of rules of the game. We should, therefore, fundamentally re-examine the role of the Fed and the supervision of our financial institutions. Are the current arrangements within the Fed structure adequate – from its regional representation to its compensation for chairman and governors to its terms of office for governors? How can the Fed’s decision-making process be improved? If we were to create a new central bank from the ground up, how would it differ? At a minimum, the Fed’s sensitivity to financial excesses must be improved.

John Maynard Keynes often employed flowery language like "animal spirits" and "liquidity trap" to describe things he did not understand. He was, after all, more of a bureaucrat than an economist. In fact, he would best be described as an anti-economist because he eschewed things like supply and demand and held the opinion that government could run the economy. So, for example, he could not understand why people would invest resources in risky adventures that helped keep the economy growing at full employment. He therefore substituted "animal spirits" for the profit motive. These spirits allow entrepreneurs to proceed with a naïve confidence and to set aside concerns over losses. Similarly, the failure to invest was also a psychological problem that he dubbed the "liquidity trap." This trap occurs when investors seek liquidity in cash and when monetary policy — in terms of cutting interest rates — no longer produces an increase in investment.

The problem with Keynes is that he thought that if entrepreneurs lose their collective nerve, the government should socialize investment, prop up demand and employment, and provide assurances to drive the economy back to full employment. He did not understand how the economy works so he could not understand how the economy corrects itself once a contraction occurs. The problem for us is that Bush, Obama, Geithner, and Summers are all following the Keynesian playbook, with Nobel laureate Paul Krugman serving as head cheerleader. If instead we just allowed the free-market process to work, the economy would likely have already bottomed; companies like AIG would be emerging from bankruptcy and the unemployment rate would be dropping instead of continuing to rise.

The market process was curtailed just a few months into this contraction and — over the last 15 months — has been almost wholly replaced with government intervention. Many of the interventions have been rightly described as "unprecedented" in that they are completely untried. This means that neither market participants nor policy makers have experience with them — and it shows. This slew of interventions has been disorderly. Many interventions, like the takeover of AIG, were total surprises, causing volatility in stock markets. Moreover, these interventions have been extremely large and wide ranging in scope. Measured in dollar terms, the money "allocated" totals over $12 trillion by one account. Ironically, by adopting the Keynesian position that we have lost our "animal spirits" and are suffering from a psychological problem of fear, the government has undertaken extreme policy changes that greatly undermine the profit motive. Entrepreneurs are no longer looking for new profit opportunities in the economy. Instead, they are more likely either trying to preserve their capital or lining up for a government bailout.

Preservation of capital requires that you place your wealth in low-risk assets like government bonds, cash, CDs, and gold. So people are saving more and paying down debt to protect themselves, but in Keynesian terminology, we have fallen into the very dangerous liquidity trap. For Keynes, the liquidity trap occurred when frightened consumers attempted to save more and consume less. He reasoned that less consumption would hurt businesses and production and therefore put businesses and labor at risk. These lower incomes would mean, in turn, that the attempt to save more would actually result in a much worse economy. The liquidity trap is really about hoarding and saving. While hoarding has a bad name among economists, it actually is a very good thing. Typically, people do not hoard resources irrationally or for no reason; they hoard as a way to protect themselves from dangerous situations. Depression, inflation, war, and other calamities are typically what cause people to hoard.

Not only does the increased saving help the economy, but hoarding is actually a good thing because it helps facilitate the process of deflation and deflation helps bring about recovery. If people reduce consumption (demand) then prices fall, particularly in the early stages of production. As all types of resources and goods are becoming cheaper, including labor, the purchasing power of every hoarded dollar increases. All the prices that were bid up during the boom — particularly land, capital, and various asset classes — are thus reset at lower levels. Debt is liquidated and savings are restored and the prospects for a return to prosperity emerge, first among producers and then by consumers. Therefore hoarding speeds up deflation and deflation speeds up the correction process.

But Keynesians are afraid of this process because they don't understand how it leads us back to full employment and economic growth. I have named this fear apoplithorismosphobia. Joseph Salerno has shown that there is no theoretical basis for this fear and Greg Kaza has shown that there is no empirical basis for this fear. Ironically, it is Keynesian policies, such as bailouts, stimulus packages, and inflation that should be feared, because they can threaten our animal spirits for profit and leave us stuck in the liquidity trap for many years. Hoarding eventually fixes most balance sheets, but in a Keynesian-dominated economy, it takes an extremely long time. During the interval, people can become permanently jaded about the market and investing. They may become permanent hoarders. This is what happened to many Americans who lived through the Great Depression. Frugality and thrift, while admirable, became a kind of psychological scar they wore for the rest of their life.

Keynesian-style policies have resulted in disasters such as the Great Depression, the "stagflation" in the United States from 1970 to 1982, and the aftermath of the Japanese Bubble. Each lasted more than a decade. It would be far better to allow for an unobstructed free-market correction process. With no government safety net or bailouts, there would be more hoarding, faster deflation, more bankruptcy, and a speedy return to prosperity. While bankruptcy sounds horrible, it is actually a wonderful and orderly process. First of all, it fixes balance sheets quickly. It also provides an opportunity to remove current owners and administrators who operated businesses in a risky fashion. No need to worry about bonus questions here! Some bankrupt firms will go completely out of business and their resources will be auctioned off to other entrepreneurs at very low prices. I would imagine that the dozens of startup firms working to bring electric cars to market would love the opportunity to buy an auto plant in Michigan for pennies on the dollar. Other firms will remain in business with most workers keeping their jobs, but bankruptcy reduces debt and cost and provides an opportunity to renegotiate contracts and wage rates.

The resulting environment after bankruptcy is one of new owners and operators with far less debt who have not had their "animal spirits" crushed. Firms would have less debt and therefore lower cost structures. Some consumers would be flush with hoarded cash and have an opportunity to buy at much lower prices. The economy enters recovery mode and can quickly attain full employment and economic growth. Most importantly, by not bailing out the losers, there is no moral hazard that entrepreneurs will believe they can rely on bailouts in the future. Because they do not understand how the market works, Keynesians think this is a fantasy. But if you follow the Austrian recipe of allowing liquidation of bankrupt firms and debt, allowing prices to fall without monetary inflation, not propping up employment or subsidizing unemployment, and not discouraging hoarding, you will end up with the quickest possible recovery and minimize the magnitude of economic pain.

The British government is confident it will find buyers for the record number of gilts it will issue in the coming year to cover the enormous budget deficit, the Treasury said today. "We are confident that in 2009/10 the demand will be there for UK paper, because we have set out a transparent, realistic and credible consolidation plan for the public finances in the medium term," the Treasury's chief economist, Dave Ramsden, told a select committee hearing. "Investors are looking at UK government paper and think it is something they want to invest in and they are doing so significantly," he added.

There have been growing concerns that the Debt Management Office's planned sales of £220bn of gilts in the current fiscal year will struggle to find buyers. But Ramsden pointed to the fact that while gilt issuance had been strong in the past couple of years, as a result of growing deficits, demand for them had been "very, very strong" across a total of 58 auctions.He stressed that the DMO would not just use auctions to sell its gilts, but syndicated sales and mini-tenders. The Bank of England is also in the process of buying nearly £75bn of gilts as the centrepiece of its "quantitative easing" strategy designed to pump more money into the depressed British economy. Ramsden also defended the Treasury's forecast that the budget deficit would be around £175bn, saying this was in the middle of a broad range of forecasts from independent economists.

He said the reason this total was far bigger than the £118bn shortfall that the chancellor, Alistair Darling, had forecast as recently as November's pre-budget report. "We and every other forecaster underestimated the severity of the world recession. But we think our new fiscal forecasts are realistic," he said. As he spoke the DMO enjoyed strong demand for £3bn of gilts due in 2022. The auction was oversubscribed by 2.25 times, well ahead of the 1.36 times cover that an auction of similar stock in February. Gilts prices rose on the news, having been buoyed earlier in the day by fears that swine flu could hurt the world economy. The benchmark 10-year gilt yield nudged down to around 3.44%, down from the post budget high of 3.5% hit at the end of last week.

Shoes, coins and documents were thrown at executives of Fortis, the Belgian-Dutch financial group, today as angry shareholders sought to prevent the sale of its banking business to BNP Paribas, the French giant. As hundreds of investors swarmed around the stage chanting 'resign' at directors, the meeting was halted and board members retreated under the protection of 50 security guards. After a second interruption, opponents stormed out of the meeting ahead of a vote on the sale, which was approved by 73 per cent of the shareholders still present But legal challenges appear certain amid claims that the vote was tainted by the presence of shareholders acting secretly for French government interests.

Amid scenes reminiscent of football stadiums, investors booed and whistled Jozef De Mey, the chairman of Fortis Holding, at the meeting in Ghent . Opponents accused him of selling out to France and demanded a change on voting procedures before a decision on whether to approve the €10.4 billion sale to BNP Paribas. 'Only in Belgium do we sell the jewels for a song," said Mai[circumflex]tre Mischakl Modrikamen, a lawyer representing 2,600 shareholders. 'The board members are refusing a simple vote. How is it possible? It's incomprehensible.' When one small Belgian investor said he would be forced to sing La Marseillaise if the deal went through, the conference room broke into an ironic chorus of the French national anthem.

When another shareholder repeated the call for Mr Mey to resign, a crowd of detractors stood up, pumping their fists and hurling insults at him. "I had placed all my savings with Fortis," said Ancion Guillaume, 25, a university lecturer who invested €50,000. "When I bought, they told me it was a solid investment. They were at 25 euros per share. Today they are about one euro." The mayhem was the latest chapter in an increasingly fraught bid by the Belgian government to rescue Fortis threw its sale of its banking assetss to BNP Paribas. After nationalising the group's banking business last autumn, Belgian ministers planned to sell its to the French group without consulting investors. But opponents won a court ruling forcing a vote on the issue, and then rejected the sale in February. Under a second version of the deal, agreed in March, BNP Paribas will take 75 per cent of Fortis' Belgian bank for €8.3 billion, 25 per cent of Fortis insurance for €1.375 billion and acquire Fortis Luxembourg for €800 millions.

The [deal] must also be approved at a second meeting of shareholders in Utrecht, the Dutch city tomorrow. But opponents dispute the right for recent shareholders to participate in the vote, saying many are acting on behalf of the French authorities. The sale will make BNP Paribas the biggest bank in the eurozone by deposits, with more than 20 million customers and a total of €540 billion in their accounts. The group will manage assets worth €660 billion. Under an agreement signed by Belgian authorities Sunday, Fortis' toxic assets will be purchased by Royal Park Investments, a bad bank set up to purchase its structured credit portfolio for €11.4 billion.

U.K. banks including Barclays Plc, HSBC Holdings Plc and Lloyds Banking Group Plc are having as many as four times more employees interviewed during routine inspections as the nation’s financial regulator’s "light touch" morphs into an iron fist. As many as 150 people are being questioned by the Financial Services Authority during examinations at Britain’s biggest banks, according to lawyers and a person familiar with the visits. In previous years, the maximum for a major bank would have been 40 interviews, they say. "The FSA is becoming nastier," said Sara George, a former FSA prosecutor who is now a regulatory lawyer at Allen & Overy LLP. "There is a feeling that the FSA is now a lot more answerable to Westminster and to the taxpayer than to the City," she said, referring to the home of Parliament, and London’s financial district.

The regulator, criticized by lawmakers for not doing enough to prevent the financial crisis, has broken with its past approach, promising more intrusive regulation and warning that people "should be frightened" of the FSA. It has pledged to become more involved in banks’ business, from scrutinizing strategy to influencing hiring and compensation. The U.K. now owns stakes in Royal Bank of Scotland Group Plc and Lloyds, while Northern Rock Plc and Bradford & Bingley Plc have been nationalized. The International Monetary Fund last week estimated the total cost of bailing out British banks will be 175 billion pounds ($255 billion).

Prime Minister Gordon Brown, who created the FSA in 1997 when he was Chancellor of the Exchequer, had up until the credit crisis championed London’s "light-touch" regulation for being business friendly. "Where more people are interviewed, that is in line with our more intrusive approach," said Heidi Ashley, an FSA spokeswoman. FSA inspections are known as ARROW visits, which stands for "advanced, risk-responsive operating framework." Before this year, they consisted of assessments of financial companies’ compliance and risk-management. "Whereas before an ARROW visit may have taken in 20 to 40 people, now it’s over 100," said Carlos Conceicao, a former FSA enforcement director who’s now a regulatory lawyer at London- based Clifford Chance LLP.

The FSA interviewed about 80 people at one of Britain’s biggest banks in the final quarter of 2008, according to a person familiar with the visit. The bank was told that more than 100 will be interviewed next time, said the person, who declined to be identified because the inspections are confidential. Non-executive directors are now being questioned more intensely and are being asked to provide evidence of where they disagreed with management and how they made their views known, said George at Allen & Overy. "The FSA is doing two things," said Jonathan McMahon, a former FSA bank supervisor who is now a regulatory adviser at the consulting firm Promontory Financial Group. "It’s asking more detailed, probing questions. It’s also interviewing people previously untouched by ARROW," including more junior employees.

The FSA’s more intensive approach can also be seen in the time it takes to approve applications for roles of "significant influence" at companies, said Darren Fox, a regulatory lawyer at London-based Simmons & Simmons. The regulator is undertaking "far more" interviews before signing off on such appointments, Sally Dewar, the FSA’s Director of Wholesale and Institutional Markets, said yesterday at a conference in London. Overhauling the ARROW visits mirrors the "revolution" in regulation that its chairman, Adair Turner, promised last month. ARROW "has embodied our principles-based approach, delivering a lighter regulatory touch for those firms that pose less risk," an FSA paper said in 2006.

The light-touch approach was criticized by opposition Conservative Party lawmakers who have recommended that bank supervision be returned to the Bank of England should they win the next general election, which must be held by 2010. Turner, presenting his blueprint for regulation, said last month the era of light-touch regulation was dead. Turner pledged that after a recruitment drive, as many as 20 supervisors will be assigned to each large bank to undertake more rigorous assessment. "They’ve got 100-odd new supervisors and one of the great unknowns is how quickly they’ve been brought up to speed," Conceicao said. "If they’re not the right caliber with the right experience, then you’ve got inexperienced people looking at vast amounts of information."

The financial crisis has brought to light scams such as the $65 billion Ponzi scheme to which Bernard Madoff pleaded guilty on March 12. He faces as many as 150 years in jail for using money from new investors to pay off old ones. "No one wants to be the one who misses the red flags of the next Ponzi scheme and so the FSA is adding a whole new layer of scrutiny," said Simmons & Simmons’s Fox. While the FSA is responding to politicians’ concerns by asking for more information, it could also be setting itself up for more problems, Fox said. "The more information the FSA asks for, the more risk they take that if something goes wrong, they will have missed it."

Tens of thousands of German investors who had bought Lehman Brothers certificates lost their savings when the bank went under. Now one savings bank has admitted giving its customers the wrong advice and is offering compensation. When the US bank Lehman Brothers went bust last September, tens of thousands of private German investors who had bought supposedly safe Lehman securities got burned. Since then, they have held protests and demanded compensation from their banks, claiming they were not warned of the risks. Now a German bank has admitted that it gave customers the wrong advice relating to the purchase of Lehman Brothers certificates. According to a report on the German public television station ARD, the savings bank Frankfurter Sparkasse (Fraspa) said it had discovered that "in a very small number of cases the advice did not meet our quality standards."

In a statement confirming the television report later on Monday, the bank also said it had offered to compensate customers as a gesture of goodwill "in a small number of cases of financial hardship." Fraspa began to compensate individual clients who had invested in Lehman certificates in March. It concentrated on investors who had been particularly hard hit when their securities lost their value after Lehman Brothers went bankrupt. However consumer rights advocates have criticized the bank's approach to compensation. "Arbitrary compensation given at the whim (of the bank) is unacceptable," Hartmut Strube from the North Rhine-Westphalia Consumer Rights Center told ARD. Many investors who were sold the Lehman certificates -- which were specially developed for the German market -- are suing their banks because they claim they were not informed that they risked losing all their money should the bank go bust.

Many of the customers were pensioners who thought they were buying rock-solid investments. The banks are accused of deliberately targeting unsophisticated older clients who they dismissively referred to as "AD" customers, which stood for "old and dumb" in German. Unlike normal savings accounts, the securities were generally not covered by Germany's deposit protection scheme, which guarantees investments in the event of banks going bust. Consumer rights organizations estimate that around 40,000 people in Germany lost money when Lehman went under. Some of the banks have already offered voluntary compensation to their clients. The Hamburger Sparkasse savings bank announced in February that it had already compensated 1,000 of a total of 3,700 investors affected by Lehman's collapse. Fraspa was one of the German savings bank which sold the most Lehman securities, flogging around 5,000 Lehman certificates to their clients. The German branch of Citibank, which is now owned by France's Crédit Mutuel, and Dresdner Bank were also active in selling the certificates to their retail customers.

9 comments:

The following statement in the conclusion, sounds like what you have been saying:

"The quantum of asset price deflation underway post the collapse of the Weimar Republic type Quadrillion dollar paper asset bubble is so large that all the kings horses and all the kings men may not be able to put Humpty Dumpty together again."

I don't get why Denninger continues to ask for the cops, because he has to realize that all the cops are in on it.

We are *NOT* a nation of laws (we have only a *political* justice system) -- we are a nation of (crooked) men, and you are about to see the chaos which results (and, in fact, you are seeing the very start of it).

Mr. Denninger: The reason you don't see Congress calling for the action you desire, and the reason you don't see "the cops" is that the moment that such action would take place, the United States government, and the United States itself, would cease to exist.

You would have maybe a Senator (or two) and maybe a handful of US Reps. You'd lose most every Governor, the entire Cabinet, the remaining US Congress, and Obama and Biden.

You would have NO government. Your only option would be revolution, Mr. Denninger.

He also speaks of that the government has to be honest about the state of the banks.

Immediate fatal bank run on everything the moment that happens. They've already committed at least one stick-save on the banking system (9/11/08), and probably more, to prevent this.

Related to Starcade's expressed opinion that we are not "a nation of laws", we are "a nation of (crooked) men", here's a comment I posted at Paul Krugman's New York Times blog recently. It took them several days to decide to allow it through. In his blog post "A Defining Moment" Krugman said that in the post-9/11 environment, our nation had failed a moral test when it stampeded into an obviously lie-based war. He said, "Not many [stood up against the lies] — and those who did were treated as if they were crazy. For me and many others that was a radicalizing experience; I’ll never trust 'sensible' opinion again."

I wrote:

Dr. Krugman, you speak of “a great national moral test — a test that most people in influential positions failed.” I agree.

William Black, whose experience in overseeing the investigation of the savings and loan scandal is described in his book “The Best Way to Rob a Bank is to Own One”, says the same thing about our current financial crisis - that it is a result of not just bad judgment, but crimes - committed by banksters in both low and high places.

The transcript of Bill Moyers interview with Black is available on the web, as is Jack Willoughby’s interview with Black for Barron’s.

I’d be very interested in your comments on Black’s viewpoint.

To be quite clear about my own perspective -

(and my faith in “sensible” opinion was destroyed during the Vietnam War, when I was in danger of being required to join the Army for the purpose of killing foreigners for two years, or the rest of my life - whichever came first) -

it seems clear to me that if the laws were enforced, there would be a large turnover in the ruling elite -

and in order to prevent this “collapse of the system” (from their perspective), the ruling elite has decided that the laws should collapse instead.